US economic indicators are blaring, but is it an alarm clock or a fire alarm?

Tai Hui says that based on US Treasury yield curves, bond investors are more optimistic about near-term prospects than the long term. So does that mean it’s time to dump risky assets? Not exactly, but it’s a good idea to review your portfolio

It’s never a good idea to ignore an alarm, whether a fire alarm or your alarm clock in the morning. However, people handle these two types of alerts differently. Most would dash for the exit as soon as they hear a fire alarm. For a wake-up call, some may hit the snooze button. And there are always a handful of people who ignore this alert altogether and regret it in the morning rush.

As the US Treasury yield curve continues to flatten, investors are discussing whether a yield curve inversion, where long-term interest rates are lower than short-term interest rates, is a fire alarm screeching to escape risk assets or just a wake-up call to review their asset allocation.

In reality, it is more the latter. Curve inversion is not an immediate trigger for bear markets and market participants need to combine this signal with other indicators to make rational investment decisions.

Yield curve inversion implies that the interest rates on long-dated (typically 10-year) US Treasury bonds are lower than the short-dated (two-year) bonds. Currently the difference between two-year and 10-year US Treasury is 30 basis points (or 0.3 per cent), a low point since the global financial crisis. The current direction suggests that the 10-year yield could be lower than the two-year by the end of the year, that is, we get an inverted yield curve.

Why do investors worry about yield curve inversion? Because it tells us bond investors are more optimistic about the near-term prospects of the United States economy than the long-term, implying the expectation of weaker growth, or even recession. In the past 50 years, yield curve inversion has preceded every recession in the US.

Hence, the possibility of this signal returning by the end of this year is creating fear that US economic growth could be at risk, with negative implications on equities and other risk assets. Despite strength in consumption and broad economic growth in the US, the ongoing trade tension between the US and China is increasingly feared as a trigger to tougher times ahead.

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Outright yield curve complacency would be dangerous, but we need to be clear about some fundamental changes in the curve’s characteristics and the global environment in recent years.

First, following several years of quantitative easing, where major central banks aggressively bought government bonds to help keep interest rates low, the growth expectation shown by the yield curve could potentially be distorted. The Federal Reserve also noted in its June Federal Open Market Committee meeting that a flatter yield curve could be brought by a number of factors, including “a lower level of term premiums in recent years relative to historical experience, reflecting, in part, central bank asset purchases”.

Second, recessions and bear markets are not imminent following curve inversion. On average in the past seven recessions, the US equity market peaked eight months after the yield curve inverted, and recession started six months after the market peaks.

Having a game plan when this situation comes can help to calm nerves and allow investors to make rational choices.

Sufficient diversification between equities and fixed income is one way to get prepared. Cash may be considered “safe” and deposit rates in Hong Kong have been slowly rising, but the purchasing power of cash is still being eroded by inflation. Global government bonds should provide a better income generating ability than cash, with lower volatility than equities.

Rotating portfolio strategy from capital appreciation to income generation, including moving from growth sectors to more defensive sectors with higher dividends, is another way to weather the next phase of the economic cycle without losing sight of the long term.